Aggregate Expenditure Components

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Aggregate Expenditure Components

Chapter 24

© 2006 Thomson/South-Western

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Exhibit 1: Disposable Income, Consumption, and Saving

The relationship between disposable income and consumption has been relatively constant and stable over timeSaving is the difference between disposable income and consumption

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Exhibit 2: U.S. Consumption Depends on Disposable Income

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The Consumption Function

The relationship between consumption and income, other things constantConsumption is the dependent variable Disposable income is the independent variable.

Because consumption depends on income, it is a function of income

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Exhibit 3: The Consumption Function

Both disposable income and consumption are measured in real terms, or in inflation-adjusted dollarsConsumption increases with disposable income, assuming other determinants of consumption remain constant

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Exhibit 4a: Marginal Propensity to Consume

Slope of the consumption function equals the marginal propensity to consumeIn this case, the change in consumption is $0.4 trillion and the change in income is $0.5 trillion: the marginal propensity to consume = 0.4 / 0.5 or 4/5

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Exhibit 4b: Marginal Propensity to Save

Income that is not spent is savedHere, saving increases by $0.1 trillion as a result of a $0.5 trillion increase in incomeThe marginal propensity to save, MPS, equals 0.1 / 0.5, or 1/5Generally, MPC + MPS = 1

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Nonincome Determinants

What are these factors that could cause the entire consumption function to shift?Net wealth and consumptionPrice levelInterest rateExpectations

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Net Wealth

Net wealth is the value of all assets that households own minus any liabilities, or debts owed

A decrease in net wealth would make consumers less inclined to spend, more inclined to save

Increase in net wealth increases consumption

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Exhibit 5: Shifts in the Consumption Function

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Real disposable income

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•Increase in net wealth shifts consumption function from C to C''•Decrease in net wealth shifts it from C to C'

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Shifts and Movements Along

Difference between a movement along the consumption function and a shift of the consumption function

Movement along the consumption function results from a change in income

Shift of the consumption function results from a change in one of the nonincome determinants of consumption

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Price Level

When price level changes, real value of dollar-denominated financial assets (bank accounts, cash) also changesIncrease in the price level reduces the

purchasing power of wealth held in fixed dollar assets – households consume less and save more

Decreases in the price level increase the purchasing power of wealth held in fixed assets – households consume more and save less

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Interest Rate

InterestThe reward savers earn for deferring consumption The cost paid by borrowers for current spending

power

The higher the interest ratehigher the interest rate, the less is spent on items purchased on credit (households save more and borrow less) and the consumption function shifts downward

Conversely, a lower interest rate shifts the consumption function upward

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Expectations

Changing expectations about price levels, interest rates, job security and other such factors influence consumer behavior

If expectations become more pessimistic, then consumption function shifts downward

If expectations become more optimistic, then consumption function shifts upward

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Investment

Investment consists of spending onNew factories and new equipmentNew housingNet change in inventories

Firms invest in capital goods now in the expectation of a future return

Since return is in the future, investors must estimate how much a particular investment will yield in all years of its productive life

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Demand for Investment

Firms buy new capital goods only if they expect this investment to yield a greater return than other possible uses of their funds

The expected rate of return equals the annual dollar earnings expected from the investment divided by the purchase price

Market interest rate is the opportunity cost of investing in capital

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Exhibit 6: Rate of Return on Golf Carts and the Opportunity Cost of Funds

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Exhibit 7: Investment Demand Curve for the Economy

•Shows the inverse relationship between the quantity of investment demanded and the market interest rate, other things constant. •Sums the investment demanded by each firm at each interest rate. •At lower interest rates, more investment projects become profitable for individual firms, so total investment in the economy increases.

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Planned Investment and Income

Investment depends more on interest rates and on business expectations than on the prevailing level of income

Thus, the investment decision is said to be “forward looking,” based more on expected profit than on current levels of income and output

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Investment Function

The investment function isolates the relationship between the level of income in the economy and planned investment – the amount firms would like to invest, other things constant

Two determinants of investment assumed to be constant areThe market interest rateBusiness expectations

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Market Interest Rate

A decline in the rate of interest, other things remaining constant, will reduce the cost of borrowing and increase planned investment: investment function shifts upward

Conversely, when the interest rate increases, the planned investment function shifts downward

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Exhibit 8: Planned Investment Function

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Real disposable income (trillions of dollars)

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1.1 I"

0.9 I'

The horizontal investment functions imply that planned investment does not vary with real disposable income, it is autonomous

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Business Expectations

The primary determinant of investment is business expectations

If firms become pessimistic about profit prospects, planned investment will decrease at every level of income

On the other hand, if profit expectations become rosier, the investment function will shift upward

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Business Expectations

Factors that could affect business expectations – and investment – include:WarsTechnological changeChanges in the tax structure Other destabilizing events that make

long-term planning more uncertain

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Exhibit 9: Annual Percentage Change in U.S. Real GDP, Consumption, Investment

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Government Purchase Function

Government purchase function relates government purchases to the level of income in the economy, other things constant

Decisions about government purchases do not depend directly on the level of income in the economy

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Transfer Payments

Transfer payments are another government outlay Outright gifts from governments to households and

are thus not considered part of aggregate expenditure

Social SecurityWelfare benefits and Unemployment benefitsMake up about a third of government outlays

Transfer payments vary inversely with income – as income increases, transfer payments decline

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Net Taxes

Governments impose taxes to fund expenditures

Net taxes equal taxes minus transfers and are independent of income

Taxes tend to increase with income while transfers decrease with income

Net taxes affect aggregate spending indirectly by changing disposable income, in turn changing consumption

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Net Exports and Income

How do imports and exports relate to the level of income in the economy?When their incomes rise, Americans spend

more on everything including exports and when incomes decline, Americans spend less on imports

The exports purchased by the rest of the world depends on the income of foreigners, not on the U.S. level of income

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Net Export Function

Shows the relationship between net exports and the level of income in the economy, other things constant

Exports are relatively insensitive to level of U.S. income, but imports tend to increase with incomeNet exports (exports minus imports) tend to decline

as U.S. income increases

For simplicity, assume that net exports are autonomous and independent of the level of income

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Nonincome Determinants of Net Exports

Factors assumed constant along the net export function include: The U.S. price levelPrice levels in other countriesInterest rates here and abroadForeign income levelsExchange rates between the dollar and

foreign currencies

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Exhibit 10: Net Export Function

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Exhibit 11: U.S. Spending Components as Percentages of GDP Since 1959